This week the focus of the world is once again on Greece since it has to strike a deal with private creditors to voluntary write down a big part of the outstanding debt, and at the same time it needs to strike a deal with the “troika” to receive a €130B bailout. If these talks fail Greece would almost certainly default next month when a €14.5B bond payment is due. Both negotiations are progressing slowly and the odds of a country leaving the eurozone have never been higher.

There are some interesting dynamics at work. The ECB is trying very hard to keep a formal default off the table, and is pushing for a voluntary debt restructuring. The motivations of the ECB are questionable as Nobel laureate Joseph E. Stiglitz argues in this column, but if it is indeed successful it would create a market dynamic where the value of the same security could be very different for different parties. The value of the bonds for what are traditionally the largest holders such as banks and pension funds would be cut significantly (currently talks are about a 70%+ reduction in NPV) while other buyers cannot be forced in accepting the deal without triggering a default.

At the same time the group of holdouts cannot grow too big, otherwise a deal with sufficient participation would be impossible to make (the IMF wants at least 88% PSI), and that might at the moment already be the case given the slow progress of the talks. If Greece manages to avoid a default the upside for small bondholders that do not participate in the restructuring could be very big. The bonds due on March 20 are trading for 39% of par while most bonds with longer maturities are trading around 20% of par. If you would calculate a potential IRR for the March bonds it would be some crazy high number (couldn’t resist doing the math: it’s actually a 26 million percent IRR).

But even a formal default might not be all bad. It would also force the ECB to take losses on its debt holdings, making it easier to reduce the Greece debt load to a sustainable level (current goal is 120% of GDP in 2020: still high). Greece has currently 347B in debt (139% of GDP) and it is estimated that the ECB currently owns 50B euros.

While the default risk of Greece is extremely high (just look at the 5 year CDS), a default doesn’t mean that the bonds will be worthless. I haven’t been able to find estimated recovery rates that are based on more than some very general assumptions, but if we look at historic recovery rates we see that Russia offered 18% of par in 1998 and Argentina 27% in 2001. If Greece is somewhat in the same ballpark losses won’t be astronomical if you buy the bonds at 20% of par today.

Conclusion

If Greece manages to strike a deal between the private sector and with the troika there could be a possible opportunity to exploit the decision of policy makers to pursue a voluntary debt restructuring. It would be a predatory strategy at the expense of participating debt holders, and not without risks: especially if Greece defaults after performing the debt exchange you will presumably get screwed over if you hold the original bonds, even though you would technically be in the same ship as the ECB.

Another attraction of Greek debt that it must be one of the most hated asset classes of this moment, and the following quote from Buffet might apply:

Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.

Disclosure

None, but might initiate a position.

More reading

A relevant piece from Felix Salmon: “Greece: What happens if bondholders hold out?”